Executive compensation is one of the key things to focus on when evaluating the management team of a business. Keeping a watchful eye on executive compensation is crucial to invest safely. Outrageous pay for management usually indicates the company is a ticking time bomb. Executive pay can be broken down into five components:
The base salary is guaranteed pay for the executive no matter how the company performs. The pay for top level executives varies depending on the size of the company and the industry. Needless to say, the financial industry executives tend to get the biggest slice of the pie that ranges in tens of millions of dollars.
However, there is a handful of CEOs who opted for $1 salary. You might think these guys are shareholder angels. On the contrary, these CEOs may make their millions in stock options or other forms of compensation. Despite his $1 salary, over the last decade Steve Jobs has accumulated over 5.6 million shares of stock options worth about $500 million. In addition, Apple pays Jobs about $800,000 for the use of a Gulfstream V given to him by the company for $90 million.
Stock options are a great way to align executives' interests with that of shareholders. If the exercise price of an option is significantly above the current market price, then management is incented to push the current market price higher. Because of this, stock options usually make up the biggest component of executive pay.
Unfortunately, there are several problems with options. The first being how options are expensed. Granting stock options to executives is not free. When stock options are exercised, they have the effect of diluting existing shareholders. As long as the cost of granting the stock options are expensed properly, shareholders can decide whether the compensation is reasonable. The second problem arises when stock options are backdated. In the past, companies were only required to report the granting of stock options within two months of the grant date. This rule allowed companies to grant stock options during an opportune two-month period where the stock price was low at the beginning and high at the end. The grant date will then be recorded as the beginning of the two-month period thus locking in an instantaneous gain! The SEC has caught on to this shenanigan and enforced a two business day reporting rule instead. Be sure to check out Options Backdating, Spring Loading for the low-down on options backdating.
The third component in an executive pay package is bonus. Executives are typically awarded pay-for-performance monetary rewards to encourage them to increase the company value. Again, the theory behind bonuses is that it motivates executives to enrich the shareholders by meeting certain targets such as earnings per share.
But the problem with bonuses often lies in the target set for the executives. If the target set is short term and easy to manipulate accounting wise, the executives will end up being incented to lie to earn their bonuses. This is most evident in Countrywide's Chairman and CEO Angelo Mozilo. During the real estate boom between 2004 and 2007, Mozilo cashed in over $400 million worth of stock options by lowering lending standards in order to meet short term performance targets.
In addition to the three main components of pay above, top level executives are also entitled to perks like relocation expenses, company-owned transportation, corporate jets, health insurance and personal security. Perks such as corporate jets are not all bad. Corporate jets allow executives to travel efficiently and therefore saves the company money. But when the perks can no longer be justified, investors should consider a different investment.
General Electric CEO, Jack Welch, received a luxury apartment, sports tickets and fresh flowers from the company. Barry Munitz, former CEO of The J. Paul Getty Trust, demanded a $72,000 Porsche Cayenne SUV for his company car. Macy's CEO, Terry Lundgren, drives around New York City in his armored Hummer H1 that costs sharedholders $87,000... per year! As an investor who demands safety of his investment, you ought to ask youself if elaborate parties for family members, interest free loans and $6,000 shower curtains are justifiable?
A component of executive compensation that receives less scrutiny from investors is severance package. Most executives have severance packages. Severance packages are compensation received after the employment of an executive has been terminated. Severance packages can include cash, stock options, health insurance and retirement benefits. Understandably, severance packages are necessary to some extent to protect the executives. But when it gets out of hand, the severance pay can motivate executives to do more harm.
HP's former CEO, Carly Fiona, received $21.4 million in cash and other benefits after termination. AIG's former Chief, Martin Sullivan was paid $47 million in total in severance packages when he resigned after two quarters of record losses. You can't help but wonder if the CEO is already executing his exit strategy from the day he came on board after negotiating a sweet severance package.
The first rule of investing is to invest safely. Getting in bed with wolves is not the best way to preserve capital. Investors must understand how their money is used by management. If management is spending money to enrich themselves, it's time to jump ship. You can learn find out how management is compensated by reading the proxy statements and footnotes of 10-Ks and 10-Qs. To learn more about how to evaluate management, be sure to read Evaluating Management.
Ye
Principal of Qovax.
www.qovax.com
Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California.
Base Salary
The base salary is guaranteed pay for the executive no matter how the company performs. The pay for top level executives varies depending on the size of the company and the industry. Needless to say, the financial industry executives tend to get the biggest slice of the pie that ranges in tens of millions of dollars.
However, there is a handful of CEOs who opted for $1 salary. You might think these guys are shareholder angels. On the contrary, these CEOs may make their millions in stock options or other forms of compensation. Despite his $1 salary, over the last decade Steve Jobs has accumulated over 5.6 million shares of stock options worth about $500 million. In addition, Apple pays Jobs about $800,000 for the use of a Gulfstream V given to him by the company for $90 million.
Stock Options
Stock options are a great way to align executives' interests with that of shareholders. If the exercise price of an option is significantly above the current market price, then management is incented to push the current market price higher. Because of this, stock options usually make up the biggest component of executive pay.Unfortunately, there are several problems with options. The first being how options are expensed. Granting stock options to executives is not free. When stock options are exercised, they have the effect of diluting existing shareholders. As long as the cost of granting the stock options are expensed properly, shareholders can decide whether the compensation is reasonable. The second problem arises when stock options are backdated. In the past, companies were only required to report the granting of stock options within two months of the grant date. This rule allowed companies to grant stock options during an opportune two-month period where the stock price was low at the beginning and high at the end. The grant date will then be recorded as the beginning of the two-month period thus locking in an instantaneous gain! The SEC has caught on to this shenanigan and enforced a two business day reporting rule instead. Be sure to check out Options Backdating, Spring Loading for the low-down on options backdating.
Bonuses
The third component in an executive pay package is bonus. Executives are typically awarded pay-for-performance monetary rewards to encourage them to increase the company value. Again, the theory behind bonuses is that it motivates executives to enrich the shareholders by meeting certain targets such as earnings per share.
But the problem with bonuses often lies in the target set for the executives. If the target set is short term and easy to manipulate accounting wise, the executives will end up being incented to lie to earn their bonuses. This is most evident in Countrywide's Chairman and CEO Angelo Mozilo. During the real estate boom between 2004 and 2007, Mozilo cashed in over $400 million worth of stock options by lowering lending standards in order to meet short term performance targets.
Perks
In addition to the three main components of pay above, top level executives are also entitled to perks like relocation expenses, company-owned transportation, corporate jets, health insurance and personal security. Perks such as corporate jets are not all bad. Corporate jets allow executives to travel efficiently and therefore saves the company money. But when the perks can no longer be justified, investors should consider a different investment.
General Electric CEO, Jack Welch, received a luxury apartment, sports tickets and fresh flowers from the company. Barry Munitz, former CEO of The J. Paul Getty Trust, demanded a $72,000 Porsche Cayenne SUV for his company car. Macy's CEO, Terry Lundgren, drives around New York City in his armored Hummer H1 that costs sharedholders $87,000... per year! As an investor who demands safety of his investment, you ought to ask youself if elaborate parties for family members, interest free loans and $6,000 shower curtains are justifiable?
Severance Packages
A component of executive compensation that receives less scrutiny from investors is severance package. Most executives have severance packages. Severance packages are compensation received after the employment of an executive has been terminated. Severance packages can include cash, stock options, health insurance and retirement benefits. Understandably, severance packages are necessary to some extent to protect the executives. But when it gets out of hand, the severance pay can motivate executives to do more harm.
HP's former CEO, Carly Fiona, received $21.4 million in cash and other benefits after termination. AIG's former Chief, Martin Sullivan was paid $47 million in total in severance packages when he resigned after two quarters of record losses. You can't help but wonder if the CEO is already executing his exit strategy from the day he came on board after negotiating a sweet severance package.
Conclusion
The first rule of investing is to invest safely. Getting in bed with wolves is not the best way to preserve capital. Investors must understand how their money is used by management. If management is spending money to enrich themselves, it's time to jump ship. You can learn find out how management is compensated by reading the proxy statements and footnotes of 10-Ks and 10-Qs. To learn more about how to evaluate management, be sure to read Evaluating Management.
Full Disclosure: I have no positions in the securities mentioned above.
Ye
Principal of Qovax.
www.qovax.com
Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California.
